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Three Stocks to Play the Next Fed Rate Hike

Another Fed rate hike is on the near horizon. Before it happens, you should buy these three stocks in this red-hot sector.

It’s only a matter of time before the next Fed rate hike. In fact, it’s already priced into one red-hot sector. I’ll tell you which sector in a bit. But first, I wanted to talk about Warren Buffett…

How did Warren Buffett get to be the most successful investor in the world?

Buffett was always a savvy businessperson and investor, starting several small businesses while still in high school. After finishing business school, where he studied under Benjamin Graham, Buffett worked as a stockbroker and started several investment partnerships (today we’d call them hedge funds).

Using the money he earned, Buffett eventually bought a majority stake in Berkshire Hathaway below book value. At the time, Berkshire Hathaway was a shrinking textile manufacturing firm, and Buffett later called the purchase of the company his “dumbest” investment move.

The “Secret” to Warren Buffett’s Wealth

Soon after taking control of Berkshire, Buffett bought an insurance company and made it part of Berkshire Hathaway (BRK-B) (another move he says was a mistake; the insurer would have done better on its own). But Berkshire eventually got out of the textile game—after 20 more years of trying to make it work—and insurance is now the core of its business.

Berkshire now owns 70 domestic and international insurance companies, covering everything from life insurance to reinsurance to municipal bond insurance. The company’s best-known insurance company is GEICO.

People may be more likely to associate Berkshire with one of the big-name brands that Buffett has bought or invested in in recent years—like Duracell, Kraft Heinz (KHC) or Coca-Cola (KO), but the insurance business is still Berkshire’s “secret” core component. And insurance is a great industry to be in if you’re one of the world’s greatest investors.

Insurance companies don’t actually make most of their money on the business of insuring people—although it is important that they take in more in premiums than they pay out in claims. The most profitable part of their business is investing that money. When you take out a life insurance policy, the money doesn’t just sit in a bank vault until you die. The insurance company invests it.

When times are good, insurers can make a lot of money by investing those premiums.

Unfortunately for the insurance industry, times have been anything but good recently. The stock market has been in a trendless chop for a year and a half, and interest rates are so low that fixed income investments barely pay enough to cover inflation.

One of those things is about to change.

Front-Run the Fed Rate Hike this Christmas

I can’t make any promises about the stock market (although our technical analysts think we could be on the cusp of a huge new bull market) but interest rates are on the way up. Yes, the start of their ascent has been delayed. I remember investment advisors warning—urgently—that rates were about to go up back in 2011... and every year since then as well.

The difference is that today, data on unemployment, inflation and economic growth actually support the case for a Fed rate hike. The latest nail in the coffin of near-zero rates was Monday’s ISM manufacturing index, which showed that the U.S. manufacturing sector grew in September after contracting in August. The next important data point will be released tomorrow, when September payroll and unemployment data are released. Economists are expecting 170,000 new jobs to have been added in September, keeping the unemployment rate unchanged at 4.9%.

Of course, if job gains fall short of that number, the next Fed rate hike could be pushed back slightly. Right now, futures markets are pricing in only a 52% chance that the hike will be announced in December.

But one indicator is telegraphing a high level of confidence that interest rates will get moving soon—insurance company stocks!

Even as Fed rate hike odds fluctuated wildly in August and September, insurance company stocks have climbed steadily, looking forward to higher rates and higher returns in the near future.

Even when the Fed declined to raise interest rates at its September meeting—which was expected, but far from guaranteed—the top insurance stocks barely blinked.

That tells me that big investors are starting to get into these stocks in a big way, and that these investors are committed—not just betting on month-to-month rate hike speculation.

Top Three Stocks in Today’s Hottest Sector

If you want to join these investors, you don’t have to look any further than the Cabot family of advisories, where three high quality insurance stocks have been added to our buy lists in the just the last couple of weeks.

Cabot Dividend Investor, which I write, just added Prudential Financial (PRU) to the Dividend Growth portfolio at the end of September.

Prudential is a life insurer, and also manages retirement accounts and over $1 trillion in assets. The company has vast bond holdings of its own, as well as numerous fixed income funds that attract outside investors, so changes in interest rates can have a significant impact on Prudential’s income. In theory, when rates go up, Prudential should earn more on its fixed income holdings, and may also see more cash flowing into its fixed income funds (although the value of some bond holdings will decrease).

PRU got off to a bad start this year, falling from over 80 to under 60 during the painful February selloff. The stock rebounded for most of March and April, before hitting resistance right at 80 in late April. That resistance level rebuffed the stock again in May, and PRU spent the summer chopping around below it.

When we added PRU to our portfolio at the end of September, the stock was trading at that resistance level again, and spent two weeks bouncing between 79 and 81—again despite the Fed’s decision not to raise rates in September. Heartened by the lack of sellers, we started a position right there, and were quickly rewarded as PRU broke through resistance in the first days of October.

The stock is now trading around 85, but still offers a very reasonable P/E of 8.4 and an industry-leading 3.3% yield.

But I’m not the only Cabot analyst who has noticed the strength in insurance stocks lately. My colleague Crista Huff just added another strong insurance stock to the Cabot Undervalued Stocks Advisor portfolio this week.

Crista picked American International Group (AIG), the diversified insurance company best known for its role in the 2008 financial collapse. But those days are behind it, as Crista told her subscribers:

“The company experienced tremendous trouble during and after the 2008 financial crisis, and received bailout money from the U.S. government. In recent years, AIG shed non-core businesses, improved operations, repaid its debt to the government and shored up loss reserves, including another $3.6 billion in 2015. This summer, AIG found a buyer for its mortgage insurance business for a total value of $3.4 billion. Investors should ignore recurring talk about a potential break-up of AIG into smaller pieces; it’s an unlikely occurrence because the company will lose significant tax-loss carryforwards by doing so prior to 2023.

“Now that AIG is able to focus on its future, the company is entering an aggressive earnings growth phase, which will be boosted further if interest rates increase. After EPS fell in 2014 and 2015, they’re expected to grow 84.5% and 37.6% in 2016 and 2017 (December year-end). Big reductions in operating expenses are contributing to the ongoing boost in profit. It should be noted that revenue growth is expected to be consistent, but incredibly slow.

“The 2016 and 2017 P/Es are 14.6 and 10.6, extremely low compared to earnings growth.

“The company’s long-term debt-to-capitalization ratio is relatively low at 23%. Low debt levels signal a company’s financial flexibility. In AIG’s case, the company intends to continue aggressively returning capital to shareholders. Thus far, we’ve seen that play out with share repurchases—at prices below book value—and dividend increases, on which the company spent $5.6 billion and $11.7 billion in 2014 and 2015. Management’s stated intentions also point toward another $25 billion in return of capital through 2017.”

For Crista’s full report on AIG, click here to try out her advisory.

Crista also took a quick look at some of AIG’s competitors, many of whom aren’t as prepared to take advantage of the coming era of higher interest rates. But her second pick in the sector is Allstate (ALL), the largest U.S. property casualty insurer, known for its slogan “Are you in good hands?”

As Crista wrote:

“Other major U.S. insurers are expected to see their EPS fall in 2016, including Allstate, Chubb (CB) and Travelers (TRV). Of those three, only Allstate is slated for aggressive earnings growth in 2017. Like AIG, Allstate offers a strong history of share repurchases, a low debt ratio and a low P/E. Therefore, if you’re assessing insurance companies for your stock portfolio, my suggestion is to avoid CB and TRV, buy AIG, and consider ALL.”

Any of these insurance stocks would make a smart addition to your portfolio today. Or you could be even smarter and sign up for continuing guidance on Prudential and AIG—plus lots more stock picks from me and Crista just by clicking here for Cabot Dividend Investor and here for Cabot Undervalued Stocks Advisor.

Chloe Lutts Jensen is the third generation of the Lutts family to join the family business. Prior to joining Cabot, Chloe worked as a financial reporter covering fixed income markets at Debtwire, a division of the Financial Times, and at Institutional Investor. At Cabot, she is a contributor to Cabot Wealth Daily.